Once a person decides the time is right for starting to build a retirement nest egg they are faced with the question, “Where should the money go?” There are many options when it comes to retirement savings accounts. Here are discussed the various options available to those interested in saving for retirement and a general pecking order is suggested with respect to which should be used in what order to maximize retirement savings.
Employer Retirement Plans with a Match
Employer sponsored plans where employee contributions are matched like 401k plans and 403b plans are the first place retirement savings dollars should be invested. Generous plans match employee contributions dollar for dollar and others use a percentage matching formula. Economist Milton Friedman, who popularized the familiar adage, “There’s no such thing as a free lunch,” can be forgiven for being wrong when it comes to employer retirement plans with a match. 401k plans and the like did not exist during his day and are most definitely the closest thing to a free lunch most people will find.
When an employer matches an employee’s contributions to the company's retirement plan it is like free money for the employee. Over time the matching component will likely contribute more to the growth of retirement savings than even future earnings and thus should be taken full advantage of.
In addition other advantages include tax deferral and that investments are made automatically via payroll deduction. The current annual limit for employee contributions for these types of accounts is $16,500 but limits can increase by $500 per year when the effects of inflation warrant an increase. Only after contributions to employer matched retirement plans are maxed out should consideration be given to investing money in one of the other remaining options.
Comparing the Roth IRA to Traditional IRAs
While an employer's plan with a match should be the first choice for retirement savings, it may not be the only choice. Since some employers only provide matching contributions up to a set percentage, rather than contributing unmatched funds to an employer sponsored plan after the limit has been reached, it may be wiser to invest money in one of the other retirement savings options.
An IRA would be next on the list as a preferred place to squirrel away retirement savings. There are two types, the Roth IRA and traditional IRAs. With a traditional individual retirement account, contributions are tax deferred. Tax deferred is good but the Roth IRA is tax free which is far superior. A Roth IRA is tax free rather than tax deferred because contributions are made from money that has already been taxed. The real advantage to a Roth IRA is that not only are the future withdrawals of contributions tax free, earnings on those contributions will also never be subject to federal taxation.
Taxes are the largest drag on growth of retirement savings. It is difficult to find a better deal for retirement dollars than a Roth IRA. The current annual limit on Roth IRA contributions is $5,000, but limits can increase by $500 per year when the effects of inflation warrant it.
Unlike traditional IRAs, there are no mandatory distributions that must be taken beginning at age 70-1/2. Consequently if the money from a Roth IRA is not needed during retirement it can be passed on to heirs in the form of an inheritance.
Employer Retirement Plans without a Match
Once employer matched contributions to an employer’s plan have been maxed out and Roth IRA contributions have also reached the annual limit, if any funds remain to invest for retirement, it would be acceptable to invest money in the employer’s plan even without matching contributions. The advantages continue to be a tax deferred place to park retirement savings and the ease of the automatic investments flowing directly from a paycheck. It is only necessary to move further down the chain of options from this point if additional funds are still available to save for retirement after employer plan annual limits and the Roth IRA annual limits have been reached, currently a total of $21,500.
Traditional Individual Retirement Account
A case can be made for contributing to a traditional IRA if the investment options available in an employer plan are so poor that a person would rather not contribute additional funds to an employer plan after the matching limits have been reached. In such cases, rather than contributing unmatched funds to an employer’s plan, it might make sense instead to utilize the traditional IRA option to take advantage of better investment options and still benefit from a tax deferred retirement savings vehicle.
The thing to remember is that while a person may have both a Roth IRA and traditional IRA, the annual contribution limits are the same for both and those limits apply to total annual IRA contributions. A person can in other words, only contribute a total of $5,000 to all IRAs under current annual limits. Thus maxing out a Roth IRA eliminates traditional IRAs from consideration as an option.
Reference:
Benna, Ted. Managing Your Money All-In-One for Dummies. Hoboken: Wiley, Johns and Sons, 2008. Print.
Larry Darter - Larry Darter is a freelance writer and published author with three books to his credit. He is a graduate of the Univ. of Central ...
